Sec. 1059: Adjusting More Than Basis

Sec. 1059 requires a corporate
shareholder to reduce the stock basis of its subsidiary
when it receives an extraordinary dividend from the
subsidiary within the first two years of owning the
subsidiary's stock. The procedures for recalculating
basis in that scenario are clear, but the effect of
these basis adjustments on the corporate shareholder's
earnings and profits (E&P) is not as
clear.

Earnings and Profits

E&P essentially is a
quantitative measure of a corporation's ability to make
distributions to its shareholders in excess of
distributions considered a return of capital. Although
the Code refers to E&P numerous times, nowhere does
it provide a comprehensive list of procedures necessary
to calculate E&P. Certain Code sections that clearly
have some effect on a corporation's E&P, including
Sec. 1059, provide little or no guidance for calculating
E&P. The lack of clear statutory guidance leads
practitioners, as a pragmatic matter, to look elsewhere,
including to the legislative history, IRS guidance, and
case law, for an appropriate answer.

Economic Reality Problem With the
Dividends-Received Deduction

Congress enacted Sec. 1059 in 1984
to prevent corporate shareholders from engaging in
"dividend stripping" transactions. The
following example illustrates Congress's concern when it
passed the section.

Example: Prior to the enactment of Sec.
1059, corporation P purchased 50% of the common
stock of corporation S for $500. S has undistributed E&P of
$1,000. Shortly thereafter, S declares a dividend, with P receiving a $200 dividend
distribution. P, upon receipt of the dividend,
properly claims an 80% dividends-received deduction
(DRD) under Sec. 243 equal to $160 (80% × $200) and
includes the remaining $40 in taxable income. The
distribution reduces the total fair value of S by the amount of the
distribution, thus reducing the fair value of P's stock in S.

Under the law in effect prior to
the passage of Sec. 1059, P makes no adjustment to the basis
in its S stock because the distribution is
made out of S's E&P. When P subsequently sells its devalued S stock for $300 ($500 – $200), P could claim a $200 artificial
capital loss ($300 proceeds – $500 basis). Here, P's $200 capital loss could not be
used to offset the $40 of ordinary dividend income, but
it could be used to offset P's capital gain to the extent it
had any. Sec. 1059 is designed to prevent corporate
shareholders from creating such artificial capital
losses to offset capital gains.

Sec. 1059

Sec. 1059 requires a corporation
that receives an "extraordinary dividend" on
shares of stock to reduce the basis in those shares of
stock (but not below zero) by the nontaxed portion of
the dividend. Sec. 1059(c) defines an extraordinary
dividend as any dividend that exceeds 10% of a corporate
shareholder's common stock basis (or 5% for preferred
stock). An extraordinary dividend also includes
non-pro-rata dividend-equivalent redemptions and
dividends arising by operation of Sec. 304.

In the example, S's $200 dividend distribution to P is considered an extraordinary
dividend because it exceeds $50, which is 10% of P's basis in its S stock ($500 × 10%). Accordingly, P must reduce its basis in the S stock by the nontaxed portion of
the dividend, resulting in an adjusted basis of $340
($500 basis – $160 nontaxed portion of the dividend).
When P later sells its S stock, instead of recognizing a
$200 loss, as in the pre-Sec. 1059 example, P recognizes a loss of only $40
($300 – $340), achieving a much closer approximation of
the "true" economics of the
transactions.

How Is E&P
Affected?

When a corporate shareholder
receives a distribution out of E&P, the corporate
shareholder generally increases its E&P by the full
amount of the distribution without regard to Sec. 243
(see Friedel, Galanis, and Allen, BNA Tax Management
U.S. Income Portfolio 762-3d:
Earnings and Profits, for an in-depth discussion of
the E&P rules). However, when a corporate
shareholder receives a distribution that is treated as a
return of capital-i.e., all or a portion of the
distribution is applied directly to reduce the basis of
the stock to which the distribution is made-Sec.
312(f)(2) precludes the corporate shareholder from
increasing its E&P by the amount of the distribution
attributable to a return of capital.

In the example, P receives a $200 distribution out
of S's E&P. Absent the application
of Sec. 1059, P ordinarily would increase its
E&P by the full amount of the distribution ($200).
However, because the distribution is an extraordinary
dividend, P is required to reduce its basis
in S stock by $160, the nontaxed
portion of the distribution. A question arises as to
whether, because of the reduction in basis under Sec.
1059, P's E&P should increase by only
the $40 taxable portion of the dividend.

The IRS's view is that P's E&P should increase by $40
and not by the full $200 dividend distribution (Field
Service Advice 868 (10/16/92)). This view is premised on
the analysis that a Sec. 1059 basis reduction
essentially is economically the same as a
return-of-capital distribution governed by Sec.
312(f)(2); therefore, the E&P consequences stemming
from an extraordinary dividend should produce the same
effect as a return-of-capital distribution under Sec.
312(f)(2).

Conclusion

A dividend distribution usually
increases a corporate shareholder's E&P by the full
amount of the dividend. However, if the dividend
distribution is characterized as a Sec. 1059
extraordinary dividend, the corporate shareholder's
E&P increases by only the taxable portion of the
dividend. In light of these different rules, corporate
recipients of extraordinary dividends that are
contemplating a distribution out of E&P should
review their E&P calculations to ensure that they
have sufficient E&P to fund the distribution.

EditorNotes

Annette Smith is a partner with
PricewaterhouseCoopers LLP, Washington National Tax
Services, in Washington.

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